Rewriting the rules of the american economy an agenda for growth and shared prosperity

PREFACE: THE AMERICAN ECONOMY AND ITS DISCONTENTS INTRODUCTION THE CURRENT RULES More market power, less competition The growth of the financial sector The “shareholder revolution,” the

PREFACE: THE AMERICAN ECONOMY AND ITS DISCONTENTS

INTRODUCTION

THE CURRENT RULES

More market power, less competition

The growth of the financial sector

The “shareholder revolution,” the rise of CEO pay, and the squeezing ofworkers

Lower taxes for the wealthy

The end of full-employment monetary policy

The stifling of worker voice

The sinking floor of labor standards

Racial discrimination

Gender discrimination

REWRITING THE RULES

Taming the Top

Make markets competitive

Fix the financial sector

Incentivize long-term business growth

Rebalance the tax and transfer system

Growing the Middle

Make full employment the goal

The American economy–and its discontents

Rewriting the Rules comes at a watershed political moment Americans are

anxious and angry, and rightfully so This is, of course, a book about

economics, but it is really about people

The vast majority of Americans—not just the poor—are deeply worriedabout the very basics: getting their kids a decent education, bringing home apaycheck that can put food on the table or pay the bills, saving enough so thatone day they can retire In the 2008 crisis and the deep recession that

followed, more than 10 million families lost their homes or entered

foreclosure, and 8.7 million workers lost their jobs Even now, those with ahome are worried about keeping it, and many displaced workers have eitherpermanently dropped out of the workforce or taken low-skill jobs for lesspay

However, as this book will show, these economic troubles are not a recentphenomenon, and not only attributable to the crisis Decades of meager payhave eroded not just economic security but also hope for a better future Fortoo many Americans, achieving or maintaining a middle-class lifestyle seemsincreasingly out of reach They hear about economic “growth” and

“recovery” on the news but don’t see that translated into steady income orgrowing paychecks Those at the top have more than recovered what they lost

in the crisis as the stock market has soared But not so the rest, who saw whatlittle wealth they had wiped out Ninety-one percent of all increases in

income from 2009 to 2012 went to the wealthiest 1 percent of Americans—the epitome of unequal growth

Some commentators point to other signs of recovery, especially in the jobmarket But despite a headline unemployment rate of 5.3 percent, millions

remain trapped in disguised unemployment and part-time employment Theworkforce participation rate has fallen to levels that predate women’s

widespread entry into the labor market in the late 1970s The unemploymentrate including those working part time involuntarily and those who are

marginally attached—meaning they want a job but are not actively lookingfor work—is over 10 percent In communities of color, rates are even higher,with unemployment among African-Americans double that of whites—as hasbeen true for half a century

Across every political divide, across every generational divide, and acrossour anguished racial divide, the American people are hungry for a new

direction and for solutions that will create a path to a new and widely sharedprosperity Politicians in both parties now struggle to speak the language ofinequality, trying to find ways to connect to the electorate’s anxiety The 99percent and the 1 percent have become part of the national dialogue But nonational leader has yet figured out how to explain, forthrightly and clearly,how the U.S has become a nation—with so much talent and such a trackrecord of growth and innovation—now mired in such chronic suffering Norhas anyone laid out a clear, comprehensive plan to lead the country out of themorass

It is in this moment that we offer a simple idea: we can rewrite the rules ofthe American economy so they work better—not just for the wealthy, but foreveryone

Our Answer: Rewriting the Rules

This book has been written to help explain what’s wrong with the economyand how to fix it It lays out a broad agenda for how we can rewrite the rules

of the 21st century economy to achieve shared prosperity, with enough detail

to show what needs to be done and to provide confidence that—if there is the

political will—it can be done.

This book was originally released as a report through the Roosevelt

Institute, and was intended primarily for political decision-makers But it

struck a nerve far beyond that group The New York Times called it “an

aggressive blueprint for rewriting 35 years of policies that have led to a

vast concentration of wealth among the richest Americans and an

increasingly squeezed middle class.” Time magazine said Rewriting the Rules

revealed a “secret truth” about inequality The Ford Foundation called thereport a “landmark.” Of course, politicians listened, too Senator ElizabethWarren lauded the report as “groundbreaking.” Advocates, labor leaders,members of Congress, and presidential candidates called, requesting briefingsand discussions and further explications of “the rules.” Importantly, they sawthe report as a call to action: what could we do, specifically, now, to begin tocreate a stronger economy?

What We Thought We Knew about Economics Was Wrong—and Why That’s a Good Thing

The core message here is simple: The American economy is not out of

balance because of the natural laws of economics Today’s inequality is notthe result of the inevitable evolution of capitalism Instead, the rules thatgovern the economy got us here And we can change those rules using what

we have learned in economics and what we know about the people who makethe rules and how they are chosen Best of all, changing the rules to promoteeconomic stability for American families will actually be good for the

produce the economic growth that adherents promised

There has been a radical shift in economic theory since the middle of the

20th century, and a raft of new evidence allows us to better understand thestrengths and limits of markets The evidence shows that markets do not exist

in a vacuum: they are shaped by our legal system and our political

institutions It also tells us that we can improve economic performance andreduce inequality at the same time Put simply: the notion that we have tochoose between economic growth and shared prosperity for many more

Americans is false

This is good news Inequality—at the level and of the type that we seetoday—is a choice When the rules no longer work, it’s time to rewrite them

The Role of Political Movements, Present and Past

The demand for real change is growing This is both because of what

Americans see and feel now, and what they sense is coming just around thecorner

Lackluster economic performance over many decades has moved

economic concerns from the fringe to the very center of our political debate.Wages for most Americans are stagnant, but worker productivity continues togrow; the disparity between the two is unprecedented At the top, though,CEO and bankers’ incomes soar—with no concomitant improvement in theperformance of the firms for which they are responsible Although moreflexible labor markets were supposed to bring about more job growth, thishasn’t panned out, as the country faces a deficit of some three million jobsneeded to reach pre-recession employment levels and absorb those who havejoined the potential workforce Eighty percent of the job growth we do see is

in low-wage service and retail employment This combination of growth forthe very wealthy and economic stasis and anxiety for the rest of Americans ispolitically volatile

Whereas the status quo is unsustainable, the future is no less daunting.Americans know that the economy is changing at its core We are in a time offundamental economic disruption The resulting transformation of our

economy—including changes in technology and globalization—holds bothperil and promise More and more people piece together a living as “micro-earners,” working through a variety of platforms to offer rides or rooms or

services—from cleaning to computer programming The sharing economymay bring great freedom and flexibility, but certainly requires that we update

a legal framework forged three-quarters of a century ago, when the NationalLabor Relations Act and the labor regulations that followed assumed a moresustained employer relationship and a narrower definition of what it means to

be a worker

Most Americans do not need economists to tell them that the changes andchallenges we face demand comprehensive solutions Piecemeal proposalsthat tinker at the margins of our current economic structure will not be

sufficient to get our economy back on track Indeed, it is very clear to theAmerican public that the economy is not working According to recent

polling, nearly two-thirds of Americans—Republicans, Democrats, and

independents—believe the gap between rich and poor must be addressed Wesee an increasingly powerful set of social and political movements

responding to these issues, from the Occupy movement and its successors,which focused in large part on the abuses of the financial sector, to the

advocates fighting for wage increases, racial justice, college affordability, andhousing finance They are all expressing real and deep needs and demandingaction

This book focuses on the U.S., but what has happened here has also

occurred in many other countries around the world The international rules ofthe game have also been changed, often under the influence of the same

misguided economic theories, reflecting the same ideologies and similar

economic interests In some cases, America has been seen as a role model; inothers, it has used its influence at the World Bank, the IMF, the WTO, the G-

20, and in other international settings to force the kind of changes that led tomore inequality and poorer economic performance onto other countries

The Window of Opportunity

At this time of widespread calls for change, Rewriting the Rules provides an interpretation of why our economy has been failing, and, on the basis of that

analysis, a set of prescriptions that go well beyond tinkering at the edges Theslowing of our economy and the increase in inequality are two sides of the

same coin Changes instituted over the last thirty years have led to an

increase in short-sighted behavior, with less spending on the kinds of term investments, including investments in people, that would generate highrates of sustainable growth This short-term behavior has created an unstableeconomy, and we are still suffering from the fallout of the last major crisis

long-We have created a so-called market economy that is rife with distortions,which enrich the top and stifle long-term growth Creating shared prosperity

is not just a matter of redistribution—redistributing after-market income

through taxes and transfers—though that is very important We must alsoincrease wages, well-being, and ultimately economic and political power for

the majority of Americans Based on this set of observations, Rewriting the Rules suggests a comprehensive menu of answers, demonstrating that, in fact, there is something—in fact, many things—we can do to fight inequality at the source, which would at the same time create a more stable and faster-

growing economy

In today’s gridlocked political environment, this might sound like an

impossible task But we can take inspiration from the past The Progressivemovement at the turn of the 20th century sought to protect and ultimatelypolitically engage all Americans, including working people, as the Americaneconomy shifted radically away from the farm and agriculture to industry andfactory jobs These ideas culminated in real change Theodore Roosevelt,realizing that concentrations of economic power would lead to concentrations

of political power, sought to limit monopolies and trusts Franklin

Roosevelt’s New Deal was, of course, a new set of policy ideas designed tofight the twin concentrations of economic and political power by remakingthe social contract and improving the lot of average Americans in the then-new industrial economy; it was also a fundamental commitment to makingthose policy ideas a reality

The New Deal was far from perfect, especially in its omissions of womenand people of color, and we must work today to correct those shortfalls Butthe arc from 1892 to 1938 shows that American politics can bring togetheroutsider social movements and powerful political forces in the service of allcitizens—to make profound structural change to the rules that govern oureconomy

Today, we have the opportunity to see this happen again, and the

obligation to push for it These rules were decades in the making, and will

take a long-term effort to fully rewrite Middle- and working-class Americanshave lived in fear for too long, but as Franklin Roosevelt told us, the only

thing we have to fear is fear itself Rewriting the Rules makes the case for

pushing past that fear and taking control of our own economic future

The wide coverage of the original Roosevelt Institute report suggests thatmany of those engaged in politics both in and outside of Washington arelistening Yet the analysis and arguments here demand more—they demandaction Will our political leadership have the courage to heed that call?

Rewriting the Rules was a team effort A group of tremendous authors and

researchers, including the Roosevelt Institute’s Nell Abernathy, Adam Hersh,Susan Holmberg, and Mike Konczal, with extremely able research assistancefrom Eric Harris Bernstein, worked tirelessly to sift through massive

quantities of data, historical analysis, and numerous policy solutions to craft a

book that is both comprehensive and also pithy and persuasive If Rewriting the Rules has succeeded in achieving this difficult balance, it is because of

their acumen and very hard work

Rewriting the Rules also would not have been written without the backing

and faith of some prescient and ultimately optimistic individuals We aregrateful for the counsel and support from the Ford Foundation, and especiallyfrom Darren Walker, Xavier de Souza Briggs, and Don Chen; and the

MacArthur Foundation, with special thanks to Ianna Kachoris and Tara

Magner At just the right moment, Bernard L Schwartz, a longtime visionaryfighting for a stronger and healthier American economy, and his colleagueSusan Torricelli stepped in with support, encouragement, and advice on how

to make our arguments most effectively And, of course, the Roosevelt

Institute Board of Directors has provided regular and unflagging enthusiasmfor our efforts to make academic evidence about what is happening to oureconomy more salient in the push and pull of today’s politics Anna EleanorRoosevelt, in particular, has shown the same combination of political

acumen, human compassion, and down-to-earth common sense that her

grandparents showed in remaking the American economy and society morethan eighty years ago

We can only hope that we will show some of the same foresight, and somemeasure of the same success, today

Joseph E Stiglitz, chief economist, andFelicia Wong, president and CEO

of the Roosevelt Institute

The American economy no longer works for most Americans We pride

ourselves on being the land of opportunity and creating the first middle-classsociety, yet profound and largely overlooked changes have put the middle-class life increasingly out of reach for the majority of Americans At the sametime, we have enabled a small percentage of the population to take home thelion’s share of economic gains

The rapidly rising inequality in the United States over the past generationdisturbs and baffles economists and politicians because it is unlike anythingour economic models predict or our experience of the mid-20th century led

us to expect

What is causing this dysfunction? Economists have gone back to textbookmodels and examined reams of data to try to understand what is happening.Some point to technological change or globalization Some posit that

government has shackled the free enterprise system and hobbled business.Some say that our economy is simply rewarding the risk takers and job

creators who have earned the riches coming their way None of these

arguments gets it right This report, which sets out a new framework for

understanding and addressing current economic trends, makes the followingpoints:

Skyrocketing incomes for the 1 percent and stagnating wages for

everyone else are not independent phenomena, but rather two symptoms

of an impaired economy that rewards gaming the system more than itdoes hard work and investment

As America has created more inequality than other advanced countries,opportunity has also been undermined The American dream increasinglyappears to be a myth, and this should not come as a surprise: economies

with high levels of income inequality and wealth inequality tend to havelow levels of equality of opportunity.

The roots of this dysfunction lie deep in the rules and power dynamicsthat have prioritized corporate power and short-term gains at the expense

of long-term innovation and growth

The outcomes shaped by these rules and power dynamics do not make theeconomy stronger; indeed, many make it weaker

A minimalist agenda that treats only the worst consequences of inequalitywill not rewrite the rules and restructure the power dynamics that aredriving stagnating wages and sputtering growth

We can rewrite the rules that shape our economy to improve prospects formore Americans while also enhancing economic performance

The effects of the growth of inequality over the past third of a centurywon’t be undone overnight, and there are no silver bullets However,there are policies that can once again put the sought-after but increasinglyunattainable middle-class lifestyle within the grasp of most Americans

With these points in mind, we need to think through what the governmentdoes and does not do, with a renewed focus on how each affects inequality.Instead of taking a minimalist approach, we have to tackle the rules and

power dynamics that shape our daily lives

We must understand that reducing inequality is not just a matter of

redistribution Economic policies affect the distribution of income both

before and after taxes and transfers The tax system, for instance, may

encourage some inequality-generating activities at the expense of others As

we shall see, this is not just a theoretical possibility; it describes what hashappened in the United States

In traditional analyses based on models of perfect markets, we often

assume away the rules of the game It is as if markets existed in a vacuum,structured by some natural law, and all that the economist needs to do tounderstand changes in the economy is to study the shapes of the demand andsupply curves and the forces determining their shifts over time

Rules include all the regulatory and legal frameworks and social norms that structure how the economy works These include rules affecting property rights, the enforcement of

contracts, the formation and behavior and responsibilities of businesses, relations between workers and their employers, and obligations and protections for borrowers and lenders and

buyers and sellers in financial markets They also include rules and institutions governing key aspects of public policymaking—taxes, public spending, and monetary policy And they include the combination of written and unwritten rules that create a structural basis for

discrimination that systematically excludes broad segments of the population—namely women and people of color—from social and economic opportunity.1

But few markets are perfectly competitive; therefore outcomes depend inpart on market power, and rules affect this power Bargaining power, forinstance, determines who benefits the most from labor negotiations, and thatpower is affected by the strength of unions, the legal and economic

environment, and how globalization is structured In markets with imperfectcompetition, firms have their own form of market power: the power to setprices Likewise, the political power of various groups determines their

ability to have the rules of the market written and enforced in their favor.Our challenge, then, is to rewrite the rules to work for everyone To do so,

we must re-learn what we thought we knew about how modern economieswork We must also devise new policies to eliminate the inefficiencies andconflicts of interest that pervade our financial sector, our corporate rules, ourmacroeconomic, monetary, tax, expenditure, and competition policies, ourlabor relations, and our political structures It is important to engage all ofthese challenges simultaneously, since our economy is a system and theseelements interact This will not be easy; we must push to achieve these

fundamental changes at a time when the American people have lost faith intheir government’s ability to act in service of the common good

The problems we face today are in large part the result of economic

decisions we made—or failed to make—beginning in the late 1970s Thechanges occurring in our economy, politics, and society have been dramatic,and there is a corresponding sense of urgency in this report We cannot afford

to go forward with minor tweaks and hope that they do the trick We knowthe answer: they will not, and the suffering that will occur in the meantime isunconscionable And, as we explain, this is not just about the present, but thefuture The policies of today are “baking in” the America of 2050: unless wechange course, we will be a country with slower growth, ever more

inequality, and ever less equality of opportunity

Inequality has been a choice, and it is within our power to reverse it

Market power

noun

1 The ability to set both the terms of market exchange and the rules that govern

exchange.

What the Old Models Got Wrong

The economic experiences of the last 35 years have pulled the rug out fromunder many of our traditional conceptions of economic theory and the

trajectory of economic growth When President Kennedy said that “a risingtide lifts all boats,” he gave voice to a theory of progress that had guidedthinking in economics and policy for years.2 In the 1950s Nobel laureateSimon Kuznets suggested that, while inequality would increase in the initialstages of any economy’s development, it would eventually decrease as aneconomy became more advanced.3 While Kuznets’s observation accuratelydescribed the dramatic decrease in inequality for several decades after thestart of World War II, history since the 1970s contradicts his hypothesis.*During the last few decades, the benefits of economic growth have

disproportionately gone to the top 20 percent of the population while theshare of national income going to the bottom 99 percent has fallen.4 Incomes,especially for men, have stagnated during this time.5 More urgently, between

2010 and 2013, even as the economy was supposed to be in a recovery,

median wages fell further.6 We now know that developed economies can risewithout lifting all boats

Our economic world has been rocked as well by new understandings of therelationship between inequality and economic performance In the past, thiswas typically viewed as a tradeoff: we could only have more equality at thecost of a reduction in economic performance Arthur Okun, chairman of theCouncil of Economic Advisers under President Lyndon Johnson, once

described the apparent inverse relationship between efficiency and equality asthe “big tradeoff.”7 At that time the focus on achieving greater equality wasredistribution (more progressive taxes and transfers) These, it was thought,

would adversely affect incentives, and this would undermine economic

performance Thus, one could lessen the degree of inequality only by

sacrificing economic performance.8 But new evidence shows that nations cansuccessfully combat inequality without harming, and perhaps even whilepromoting, economic performance.9

Since the late ’70s, we have seen a decline in our growth rate, four

significant economic downturns—including the worst since the Great

Depression—and an increasing share of the limited growth that has occurredgoing to the top, with stagnant incomes for many and a hollowing out of themiddle class Evidently, trickle-down economics—increasing incomes at thetop in the hope that everyone will benefit—has not worked The new view isthat trickle-up economics—building out the economy from the middle—ismore likely to bring success; in other words, equality and economic

performance are complements, not substitutes.

The demise of these tenets of conventional wisdom has profound

consequences It tells us that we cannot take shared growth for granted, andthat we do not need to circumscribe our efforts to promote shared growthsimply out of fear that such efforts will necessarily damage economic

performance Recent research has identified the many channels through

which greater inequality hurts economic performance, and why it is that

higher GDP growth does not necessarily benefit large swaths of the

population.10

This new view emphasizes that policies that focus only on the symptoms

of our dysfunctional economy—for instance, on remedying the worst

extremes of inequality—will not change the way today’s economy is

structured nor tackle the reasons that our economy seems to generate moreinequality than the economies of any other advanced countries The

experience of the last 35 years, across many nations, suggests that rules offinance, corporate governance, and international trade all can be rewritten topromote growth and shared prosperity rather than channel more wealth andopportunity toward those who already have the most

Textbook models trying to explain inequality focus on a simple theory:each individual receives returns commensurate with his or her social

contributions Differences in individuals’ incomes are then related to

differences in productivity, skills, and effort, and changes in the distribution

are attributed, for instance, to changes in technology and to investments inhuman and physical capital Following such an analysis, much of the wageinequality that emerged in the latter part of the 20th century was attributed to

“skill-biased” technological change, the fact that changes in technology put agreater premium on certain skills, and that individuals with those skills didbetter than the rest To the extent that these skills were acquired through

education, over the long run, wage premium would induce more young

people to acquire these highly valued skills, and as they did so, the premiumwould be reduced The high level of the education premium reflected a

mismatch between the needs of the new technologies and our labor force.These were important insights, and certain policies followed: providing alarger proportion of the population with these skills would reduce inequality.But there are serious deficiencies and limitations in these theories, as wewill explain in an appendix Skill-biased technological change, for example,cannot explain why highly skilled workers have had to move into lower-skilled jobs It cannot explain what has been happening to wages in the pastdecade—even skilled workers are not doing well Nor can it explain the

magnitude of the rise of pay at the top—including CEOs and those in thefinancial sector—or the yawning gap between the growth in productivity ofworkers as a whole and average wages Historically, wage and productivitygrowth moved in tandem, but this has not been true for the last third of acentury

Of course, inequality and how the overall gains from growth get

distributed among individuals are complex phenomena caused by a number

of factors Technology, globalization, shifting demographics, and other majorforces are important, and parsing out the relative contributions of differentfactors is not simple But these forces are largely global in nature If they arethe primary drivers, all advanced countries should be similarly affected Butamong advanced economy countries, the U.S has the highest level of

inequality, so the explanation for the outcomes we see cannot lie solely inglobal factors.11 Moreover, not even the effects of global forces are out ofour control Their impact can be changed significantly by the policy decisions

we make Given the failings of the older models, we have an alternative

explanation for the extreme inequality we see today

An Emerging Approach: The Importance of

Institutions and Correcting Structural Imbalance

Our institutionalist approach is based on two simple economic observations:rules matter and power matters This approach began with a set of insightsfrom academic research Over the past four decades, economists have

increasingly drawn attention to the many ways that the standard model,

which assumes perfect information, perfect competition, perfect risk markets,and perfect rationality, fails to provide an accurate description of how variousmarkets in our economy really work Researchers including myself, GeorgeAkerloff, Michael Spence, Jean Tirole, Daniel Kahneman, Oliver

Williamson, Douglas North, John Harsanyi, John Nash, Richard Selten,

Elinor Ostrom, Rob Shiller, and others have won Nobel prizes for work oninformation asymmetries and imperfections, bargaining theory and

imperfections of competition, behavioral economics, and institutional

analysis These works provide a whole new perspective on the functioning oflabor, product, and financial markets, and essentially show that institutionsand rules are required to force markets to behave competitively, for the

benefit of all And even when markets are competitive, there can be “marketfailures,” important instances where government intervention is required toensure efficient and socially desirable outcomes

That theory has been substantiated by a number of real-life events Theeconomic crisis of 2008 and the Great Recession that followed demonstratedthat the promise of a deregulated market economy was empty Only throughconcerted government action, in the form of an $800 billion bailout, were thebanks and the market sustained.12 Further, saving the financial system didnot trickle down to ordinary mortgage holders or average workers, who lostover 4 million homes and whose real median income declined nearly 8

percent between 2007 and 2013.13

In sum, while both the traditional and institutionalist economic approachesexplain some of what has been going on, the latter theory, which focuses onstructural factors, is increasingly compelling

Wealth and Inequality

Economists are developing a new set of theories in an effort to explain theprofound imbalance we see in today’s economy, in particular the rise in

wealth relative to income In Capital in the 21st Century, Thomas Piketty

argues that r>g—meaning the return to capital is greater than the growth rate

of the overall economy—and that wealth grows faster than income as a result.This means that, if the return to capital does not decline (and he argues that ithas not), increasing inequality is the inevitable consequence of capitalism’shistorical evolution Piketty’s contributions to the debate, and the data heamasses, are important But we believe that r>g is not quite the right

explanation, or at least not the full explanation, for the runaway growth inwealth and income inequality at the top that Piketty so thoroughly

documents

One cannot either theoretically or empirically explain the growing gapbetween wealth and income as the result of steady accumulation of capitalgoods through savings out of ordinary income Moreover, if an increase inthe amount of productive capital were responsible for the increase in wealth,

we should also have seen an increase in average wages and a decline in thereturn to capital Neither of these has been observed

Much of the increase in wealth is attributable to the increase in the value offixed assets and not the reflection of an increase in productive value Themost obvious and widespread example is the massive rise in real estate

values If the value of real estate increases thanks only to the rising price ofthe property it sits upon and not to physical improvements, this does not lead

to a more productive economy; no workers have been hired, no wages paid,

no investments made In economic terms this gain is simply a “land rent.”Some of this increase in the property value is a natural consequence of

urbanization, but much is due to the financialization of the economy,

including the increased supply of credit—credit that typically goes to thosethat already have wealth Land rents are the most obvious source of rents inthe economy, but economists have identified many others, including

monopoly profits, drug pricing, patents, and other forms of intellectual

property

The capitalized value of rents gives rise to wealth, and so if rents increase,

so will wealth If monopoly power increases, monopoly profits will increase,and so too will the value of the monopolies—the measured wealth of theeconomy But the productivity of the economy will decrease, and so too willthe value of wages adjusted for inflation Inequality will also increase.

Financialization

noun

1 The growth of the financial sector and its increased power over the real economy, including the ways the values and practices of the financial sector have shaped the rest of society.

Recent theoretical work points out that there are many other examples of such

“exploitation” rents, and that changes in the rules that structure the economycan lead—and plausibly have led—to an increase in these rents and theircapitalized value.14 For instance, if the concentration of the banking systemincreases such that more banks are “too big to fail,” meaning their individualfailure could jeopardize the entire financial system, the value of banks willincrease, not because the bigger banks will become more efficient, but

because increased monopoly power and expectations of a government bailout

at some point in the future will increase their value In this analysis, we make

a distinction between capital and wealth Only an increase in the former

necessarily encourages growth; because wealth may increase simply becausethere has been an increase in rents, the productive capacity of the economymay not be increasing in tandem with measured wealth In fact, productivecapacity may be falling even as wealth is increasing

Rent-seeking

noun

1 The practice of obtaining wealth not through economically valuable activity but by

extracting it from others, often through exploitation Examples include a monopoly overcharging for its products (monopoly rents) or the drug companies getting

Congress to pass a law that allows them to charge the government very high prices

and supply fewer goods, services, and real innovation to the marketplace.

To right the economic imbalance, to reduce inequality and promote healthygrowth in the real economy, we must attack the sources of those rents

This is not about the politics of envy The evidence of the last 35 years andthe lessons of stagnation and low-wage recovery since the 2008 financialcrisis show that we cannot prosper if our economic system does not createshared prosperity This report is about how we can make our economy, ourdemocracy, and our society work better for all Americans.

How We Got Here

In the last 30 years, sometimes under the radar, our economy, politics, andsociety have shifted Where there was once a balance of powers between theprivate sector, labor institutions, and government, we now have forces pulling

us in the direction of greater inequality This means weak demand and

reduced growth It also means less long-term investment in education andresearch and development, and thus less innovation

These forces ultimately undermine the American Dream, the belief that ifyou work hard and play by the rules you will succeed Today, the life

prospects of young Americans are determined largely by the income or

education of their parents We once stood out as a country that provided thegreatest opportunity to succeed; now we stand out as one of the advancedeconomies that provide the least mobility, with a child’s income more

dependent on the education and income of his parents than in almost all otheradvanced countries

This failure to provide a fair start and a good life for our children is ofparticular concern The fact that in America today 20 percent of all childrenlive in poverty—including 38 percent of African-American children and 30percent of Latino children—is not only a moral issue but an economic one.15

If we do not invest in our children, our workers, and our nation today, we willstay on track for slower growth, higher inequality, and less opportunity in thefuture

Our economy was more balanced in the decades prior to 1980 and

functioned remarkably well during the middle of the 20th century Faced withthe disaster of the Great Depression, Franklin D Roosevelt put into place aseries of major policy changes to counteract the overwhelming and harmfuleffects of unregulated banks and stock markets The Federal Deposit

Insurance Corporation ensured the safety of bank deposits; the Glass-SteagallAct separated deposit-taking banks from those engaged in investment

activities, so that banks couldn’t use federally insured money for high-riskspeculation; the Securities and Exchange Commission enforced new marketand securities laws that attempted to protect ordinary investors, preventingmarket manipulation and insider trading; and the National Labor RelationsAct gave workers the right to bargain collectively The combination createdwhat John Kenneth Galbraith called “countervailing power” and enabled thecountry to avoid financial crisis for half a century.16 In this golden age ofcapitalism the country’s economy grew faster than in any other era, and whileincomes grew at the top, middle, and bottom, those at the bottom saw theirincomes grow faster than those at the top

Of course, even in the golden age of capitalism, markets and the economywere not perfect Systematic discrimination against women and people ofcolor meant that large groups of Americans were shuttled into low-wage jobs,like domestic or janitorial work, that were not protected by unionization.African-Americans were excluded from higher education and home loanprograms designed to provide opportunity to middle-income Americans.Deprivations faced in one generation had consequences for later

generations Beginning in the 1950s, the civil rights movement fought for andmade progress on desegregation, antidiscrimination, and voting access

Mobility increased during that generation, but these steps forward have notbeen enough Progress has been met by obstacles, and mobility has stalled

In the 1980s, under the influence of supply-side economic theories

developed during the previous decade, and driven by conservative ideologyand special interests, American policymakers began to deregulate the

economy.17 The country also lowered taxes on top earners and on the returns

to capital Then, in the 1990s, the tax on capital gains was lowered still

further Further reductions in top rates, capital gains, and dividends occurred

in the beginning of this century All of this was allegedly to encourage morework and savings The premise was that lowering taxes would increase

growth and all would benefit Reagan argued that growth would increase somuch that tax revenues would increase The results were disappointing: thehoped-for supply-side responses were not forthcoming, tax revenues fell, and

we experienced lower growth and more instability

Supply-side economic theories

noun

1 Theories that focused on increasing the supply side of the economy—for instance making conditions more favorable for businesses and investors, or lowering taxes on workers in the hope that lower taxes would elicit a large labor supply—as opposed to the Keynesian theory that focused on demand Supply-side theories hypothesized that improving incentives through lower tax rates and lighter regulations on business would lead to increased work, investment, and entrepreneurship, which in turn would lead to stronger growth with trickle-down benefits of higher employment, incomes, and tax revenues The failure of these theories to live up to these predictions has left them largely discredited among economists, though they remain popular among certain conservative politicians and ideologues.

The 1990s and 2000s brought other sweeping changes In these years, thederegulated finance sector incentivized short-termism among corporations.Much of the growth we saw in the 1990s turned out to be unstable, built onasset bubbles—first the tech bubble, then the housing bubble The “greatmoderation” turned out to be a phantasm: instead of new economic insights(for instance concerning the conduct of monetary policy) leading to a better-managed economy, we had more instability, slower growth, and more

pressure on wages Together with the increased financialization of the U.S.economy, these forces also contributed to the decline of vertically integratedmanufacturing, which brought multiple stages of the production processunder one roof.18 The culmination of all these factors is the high-rent, high-exploitation, low-wage and low-employment American economy

Short-termism

1 The post-1980s model of corporate governance that focuses on short-term profits and returns to shareholders as opposed to the long term, including long-term investments

in people and research that lead to sustainability, innovation, and growth.

Today, many place their hope in the innovative revolutions of the 1990s and2000s: the distributed technologies enabled by the Internet, the promises ofnanotechnology, and the profound possibilities of biotechnology and

personalized medicine To date, we have seen growth in some fields, themakings of strong companies, and real fortunes built on the power of theInternet But the most important economic question is whether these

technologies can help us create and distribute more growth, opportunity, andwell-being to more people Can the Internet and its yet-untapped innovativepotential become the 21st century equivalent of the 20th century’s

manufacturing sector for Americans across income levels? Or will it add tothe high-rent economy we currently face? We have seen many benefits fromweb technology, but we haven’t yet seen it drive broadly shared prosperity.Indeed, some new technologies may tend to lead to more concentration ofincome, wealth, and power

This is our challenge: For the promise of innovation to be realized, wemust first solve the legacy of problems left to us by 35 years of supply-sidethinking and the corresponding set of rules that has reshaped all aspects ofour economy and society and led to slower growth and unprecedented

inequality

Our Story of Today’s Economy

We have developed a 21st century American economy defined by low wagesand high rents Yet the rules and power dynamics embedded in today’s

economy are not always visible Think of slow income growth and risinginequality as an iceberg:

The visible tip of the iceberg is everyone’s daily experience of inequality:small paychecks, insufficient benefits, and insecure futures

Just underneath the surface are the drivers of this lived experience These

are hard to see but vitally important: the laws and policies that structurethe economy and create inequality These include a tax system that raisesinsufficient revenue, discourages long-term investment, and rewardsspeculation and short-term gains; lax regulation and enforcement of rules

to make corporations accountable; and the demise of rules and policiesthat support children and workers

At the base are the large global forces that underlie all modern economies

—drivers like technology, globalization, and demographics These areforces to be reckoned with, but even the biggest global trends, whileclearly shapers of the economy, can be shaped and pushed toward betteroutcomes

The tip of the iceberg is what we see and experience It is the most importantthing to voters and politicians; it is our daily lives But it is carried along by amass of market-structuring forces that determine the economic and politicalbalance of power and create winners and losers Just as the part of the icebergthat is below the surface sinks ships, this mass of rules is what is sinking theAmerican middle class

Often policymakers, advocates, and the public focus only on interventionsagainst the visible tip of the iceberg In our political system, grand proposals

to redistribute income to the most vulnerable and to curb the influence of themost powerful are reduced to modest policies like a limited earned incometax credit or transparency around executive pay Further, some policymakersdecry the value of any interventions, suggesting that the forces at the base ofthe iceberg are too momentous and overwhelming to control—that

globalization and prejudice, climate change and technology are exogenousforces that policy cannot address Had we curbed excesses in housing

finance, this thinking goes, the financial sector would have found some otherway of creating a bubble If we curb one form of executive pay, companieswill find more sophisticated routes to reward their CEOs

This defeatist mentality concludes that the underlying forces of our

economy can’t be tackled We disagree There is little we can do if we don’t

take the laws, rules, and global forces head on The premise of this report isthat we can reshape the middle of the iceberg—the intermediating structuresthat determine how global forces manifest themselves

This means that we can best improve economic security and opportunity

by tackling the technocratic realms of labor law, corporate governance,

financial regulation, trade agreements, codified discrimination, monetarypolicy, and taxation

The focus here on the rules of the economy and the power to set them isn’t

a call for the government to get out of the way There is rarely an “out of theway” for the government As we said earlier, markets don’t exist in a

vacuum; it is government that structures markets and sets the rules and

regulations under which they operate Rules and institutions are the backdrop

of the economy, and the ways we set these rules, and keep them up to dateand enforce them, have consequences for everyone

The Structure of This Report

If the economy is not functioning as it should or could, then we have

available to us a much broader range of policy solutions for improving

growth and equality than we typically tap The increase in inequality and thedecrease in equality of opportunity have reached the point at which individualfixes that target what we can see—fixes like modest increases in the

minimum wage and reforms to education and educational opportunity—willnot suffice While important, they should be seen more as short-term

palliatives, providing symptomatic relief We need a far more comprehensiveapproach that results in improving the market distribution of income and trueopportunity across generations An essential part of this entails dealing withthe outsized growth of the financial system and its effects on private-sectorbehavior and decision-making throughout the economy

In this report we cover what we consider to be the essential drivers of

inequality In the following section, “The Current Rules,” we describe howpublic policy decisions are at the root of rising inequality and increasing

insecurity The massive overhaul of the rules of the financial sector, corporategovernance, and labor law in the 1980s and 1990s has resulted in poor

outcomes Changes to the goals and conduct of monetary and fiscal policyhave prioritized the wealthy Meanwhile, efforts to make good on the

American promise of inclusion have stalled, and we have failed to dismantlestructures of discrimination All of the above are the result of deliberate

policy choices made with the promise that they would enhance growth, butthey have ultimately resulted in an economy that is more unequal and muchweaker

Growing inequality has reached a near-crisis level This crisis, though, isdifferent from the financial crisis of 2008, where the alternative to actionappeared to be an immediate collapse in the economy This is a subtler crisis,but the decisions we make now will determine the nature of our economy andour society for years to come If we take the wrong path, we are locking ingreater inequality and diminished economic performance If we take the rightpath, we can not only produce immediate benefits—helping preserve themiddle-class life to which so many Americans aspire—but also build toward

a future economy with broadly shared growth In the final section, “Rewritingthe Rules,” we discuss the policy solutions that are necessary for responding

to this crisis, the reforms that are needed to our underlying economic

structures, and the programs that could enable more Americans to live the life

they have worked so hard to achieve.

* Over the longer run, there could, of course, be either increases or decreases in the distribution of income as changes in the savings rate, population growth rate, and technology affect whether there is capital deepening (an increase in the ratio of capital to effective labor) However, as we argue, it is difficult for these factors to explain observed changes in inequality.

THE CURRENT RULES

Inequality has been a choice Beginning in the 1970s, a wave of deliberate

ideological, institutional, and legal changes began to reconfigure the

marketplace At the vanguard was deregulation, which, according to

adherents, would loosen the constraints on the economy and free it to thrive.Next were much lower tax rates on top incomes so that money could flow toprivate savings and investment instead of the government Third were cuts inspending on social welfare, to spur people to work Get government out ofthe way, it was argued, and the creativity of the marketplace—and the

ingenuity of the financial sector—would revitalize society

Things didn’t work out that way First, tax revenues plummeted and

deficits soared Then we saw glimmers of the instability that would lie ahead

—the financial crisis of 1989, which led to the economic recession in theearly 1990s Today, we can look back and see the toll of these “reforms”: theworst economic crisis in 80 years, slower growth than in the preceding 30years, and an unbridled increase in inequality.1 We also now know that

“deregulation” is, in fact, “reregulation”—that is, a new set of rules for

governing the economy that favors a specific set of actors

Understanding the trends of the past few decades has absorbed economists’attention in recent years Today, labor force participation sits at a 38-yearlow.2 While households had been saving, on average, less than 3 percent ofincome before the Great Recession, savings have increased following therecession—averaging 4.8 percent for the past year—though not enough tooffset lost wealth or to make much of a dent in household indebtedness, andstill not high enough to ensure sustainable growth.3 Investment has beenweak.4 American corporations are sitting on trillions of dollars of cash,

eschewing investment even though the effective corporate tax rate—the rate

they actually pay on average—has fallen.5 All of this helps explain why thepromised growth did not occur: the promised supply-side effects weren’t real.The economic model was wrong.

In the years since the 1970s the rules of the game changed in ways thatdestroyed the balance of economic power achieved in the three decades afterWorld War II In this section we examine the turns that have taken us downthis sad road, and we consider them in the light of a few lessons learned

along the way:

Fundamental changes in the rules of the economy have led to greaterinequality, not only with fewer people sharing in the economic gains, butthe economy overall and even business investment growing slower as aresult

In the private sector, finance has gone from serving the whole economy

to serving itself Corporations have gone from serving all of their

stakeholders—workers, shareholders, and management—to serving onlytop management under the guise of enhancing “shareholder value.” Andincreasing the market power of a few firms in key sectors has meant thatcompetition has less sway The result: shortsighted behavior,

underinvestment in jobs and the future, low growth, higher prices, andgreater inequality

Our tax system encourages speculation rather than work, distorts theeconomy, and serves the interests of the 1 percent

In monetary and fiscal policy, focusing excessively on some threats—budget deficits and inflation—while ignoring the real threats to economicprosperity—growing inequality and underinvestment—has resulted inhigher unemployment, more instability, and lower growth

Changes in labor market institutions, laws, regulations, and norms haveweakened worker power and made it difficult for workers to countervailthe excesses of corporate and market power The result has been a

growing gap between productivity and wages, perhaps the most strikingaspect of American economic life in the past third of a century

These problems are exacerbated for those who suffer from discriminationand disadvantage The market perpetuates the transmission of advantageacross generations, and discrimination has precluded large populations

from developing their own human capital and accumulating wealth.

This is a stark picture of a world gone wrong But these have all been

choices, meaning we can choose to do things differently We will point

toward a path forward in our final section

More Market Power, Less Competition

Competition is an essential feature of a successful economy, driving firms to be

efficient and driving down prices Competition limits the power of market actors to tip economic and political outcomes in their favor.

Significant parts of the U.S economy have strayed far from this competitive ideal, and market power is playing a larger role in areas vital to people’s well-being and to the overall economy’s performance.

Changes in technology and globalization have played a role in this increase in market power But so too have explicit policy choices made by government In many cases, the government has chosen not to keep market power in check.

Because such activities can decrease economic efficiency and stifle motivation, reining

in market power will support a more dynamic U.S economy, not just a more equitable one.

Textbook economics posits a world in which no one firm has power in themarketplace With many firms competing, no single one has the power toraise prices and its own profits because customers can buy from any number

of competitors But in the real world market power relationships are an

essential feature of our economy and are evident in numerous ways, in

relationships between businesses and their customers, businesses and

workers, and businesses and government

The ability to wield power in the market is related to the degree to whichmarkets operate in an open, transparent, competitive fashion versus the

degree to which they are dominated by one or a small number of actors; howopen or closed an industry is to entry by other firms; and the degree to whichthe same information and knowledge is shared among all participants in themarket These characteristics of a market define a spectrum of situationsalong which an empowered party can exercise power to varying degrees overothers—even when people exchange seemingly with free will.6 Power in the

marketplace spans from the traditional “natural monopolies” we teach inEcon 101—where there is only one firm from which a typical homeownercan buy electricity, for example—to the more complicated cases where

business scale and scope give a single firm, like Walmart, the power to setprices throughout the supply chain; or where a surplus of available workers in

a community gives an employer the power to set wages When we say theseentities have the power to set wages or prices, we do not mean that this power

is unfettered We simply distinguish the situation where, for instance, a firmcan raise its prices above its costs, increasing profits but losing relatively fewcustomers, from the perfectly competitive market where a firm that raisesprices would lose customers to competitors For shorthand, we take

“monopoly” to mean the scope of such varied power relationships in the

marketplace

Why there must be rules to ensure that markets remain free and competitive

Regulation to ensure the competitiveness of markets in the United States has

a long history dating back to the Interstate Commerce Commission, created

in 1887 as the first national industrial regulatory body, and the Sherman

Antitrust Act of 1890, which prohibited certain mergers and anticompetitivebusiness practices The Sherman Act, together with the Federal Trade

Commission Act and the Clayton Act, both passed in 1914, form the core offederal antitrust law They describe unlawful business practices in fairly

general terms, leaving it to the courts to decide which specific acts are illegal

on a case-by-case basis

Over time, the U.S built a number of institutions to monitor

anticompetitive practices and weigh challenges to monopoly behavior Butbeginning in the 1970s, economic ideas in the field of competition emergedfrom free-market scholars who viewed antitrust regulation as antiquated andcounterproductive in its effect on competition.7 Many key industries,

including airlines, railroads, telecommunications, natural gas, and trucking,were deregulated from the 1970s through the 1990s Legal interpretations inregulatory rulemaking and an accumulating body of case law further limited

regulatory scope and opened the domain for market power to grow

unchecked.8

Meanwhile, the government itself can vest businesses with market power

by setting the rules of the marketplace Perhaps the most clear-cut example ofthe way that policies can create market power is intellectual property rights,

or IPRs—the government-enforced temporary monopoly on the right to profitfrom an innovation Well-being generated by innovation relies on two points:first, innovators need appropriate incentives and resources; second,

innovations should be distributed widely throughout the population so thatpeople benefit from technological advances IPRs—patents and copyrights—

in theory provide incentives for innovators by offering monopoly returnsfrom their innovations for a limited period of time However, in the words ofeconomists Michele Boldrin and David K Levine, “there is no empiricalevidence that [IPRs] serve to increase innovation and productivity.”9 Otherresearch by Petra Moser examining the long-run economic history of IPRsand innovation draws a similar conclusion.10 Part of the reason for this isthat it is not just financial incentives that matter to innovators Among themost important discoveries are those that are part of the advancement of

science, from the discovery of DNA to the mathematical insights that led tothe computer (the Turing machine), rather than those made for primarilyfinancial gain Strong IPRs, perversely, can actually impede innovation in theeconomy by limiting the spillover of knowledge critical to fueling additionalinnovations.11

Though IPRs might not have much positive impact on innovation, they dohave the effect of raising the prices paid to owners of intellectual properties(who often may not be the same people as those doing the innovating) SuchIPRs effectively redistribute money from consumers to IPR owners—simplybecause government affords them greater legal protection against marketcompetition Artificially raising prices has the effect of shutting some peopleout from enjoying the benefits of innovation This is particularly disturbing inthe case of medicines, where our poorly designed IPR system, combined with

a poorly designed health care system, have condemned large numbers ofpeople to unnecessary deaths and morbidities.12

An innovation economy requires a balanced and differentiated intellectual

property regime—combined with strong direct public support, especially forbasic science and technology Over the years, our system has lost that

balance Trade agreements, for instance, have extended the effective life ofthe patent by making it more difficult for generic medicines to enter the

market

Government policies also vest companies with market power through theways in which the government buys goods and services from and sells publicassets, such as mineral rights, to the private market Procurement in the

defense industry, especially under sole-source contracting (as in the case ofthe multi-billion-dollar Halliburton contract at the beginning of the Iraq War)

is a notorious system for giveaways to government contractors.13 Another is

a provision in Medicare Part D expansion to cover part of the cost of

outpatient prescription medicine, which prevented the government from usingits bulk purchasing power to negotiate lower costs of medicines for seniorcitizens and people under 65 with certain disabilities.14 The restriction

ensured that seniors would hand more of their fixed incomes to

pharmaceutical and health insurance companies and significantly raised thecost to taxpayers

New technologies mean new sources of market power

New technologies of information and interconnectivity transform not only theway we work and live, but also the power relationships between people

throughout the supply chain Network externalities arise when an individual’sbenefit from using or doing something depends in part on the number of otherpeople doing the same thing For example, the value of joining a social

networking application increases with the number of others choosing thesame platform Once these patterns are established, it becomes costly to join adifferent network, thus vesting the first to move into a space and attract acritical mass of joiners with substantial market powers.15

New economy technologies often combine network externalities with

complementing economic characteristics of increasing returns to scale Thismeans that as production increases, the cost of producing additional unitsdecreases, and in many such cases can reach a point of essentially zero cost

for producing more In other words, it costs essentially nothing for Google orFacebook to supply one additional advertisement to users or for Apple tosupply one additional iTunes download In such situations, competition willnot be viable Market power—and monopoly profits—may be especiallylarge.

We also can see how companies like Uber, Airbnb, and Lending Club areinnovating and disrupting the way that labor, land, and capital markets,

respectively, have worked in the past These innovations of network

connectivity are in each case putting to work idle economic resources Asthese and other companies engage currently monopolistic enterprises in newwave competition, and as these companies use technology to improve theefficiency with which resources get used, there is the potential for an increase

in overall welfare But in some instances, some of the advantages of thesecompanies arises from tax and regulatory arbitrage—in circumventing

regulations, for instance, which are important to promote health and safetyand worker rights And in some cases, new monopolies will be created Thusthese innovations will also raise more questions about how the gains will bedistributed and how the rules that ensure fairness and conditions of work andother societal protections will be applied

The new technologies and our out-of-balance intellectual property regimeare not the only sources of market power There is a large body of economicresearch on natural and artificially created barriers to entry and competition

In a fast-moving, changing economy, there are likely to be information

asymmetries, and these asymmetries can lead to less competitive markets.And markets can actually act in ways that increase these information

asymmetries As we will see below, the financial market, through its lack oftransparency and complexity, has excelled at this

Globalization tilts the balance of power

Just as IPRs must balance the interests of innovators with the need for

broadly dispersed innovation, so too must trade agreements balance the needs

of an increasingly interconnected economy with the protection of

communities, worker standards, and the environment Our rules have not

successfully balanced these forces Our globalized world can bring new

opportunities for gains for all, but also can provide opportunities for largecorporations to dominate sectors of the international market, increasing

market power, or to seek lowest-common-denominator labor, environmental,

or tax laws

We live in an increasingly globalized world where rules of trade and

finance are important The problem is that these rules are typically set inprocesses that are not transparent and democratic—with those in the industryhaving greater say than consumers, workers, and other citizens who are alsoaffected It is easy to see how such rules can increase corporate profits at theexpense of workers and the environment

Rules that make it easier for goods produced abroad to enter the U.S., thatmake it safer for corporations to invest abroad, that provide tax advantagesfor investments abroad, that do not impose environmental and labor standards

on goods made abroad—all of these tilt the balance against workers Theymake a threat by a firm to move its production abroad if workers don’t acceptlower wages or poorer working conditions more credible

When the interests of all parties are considered, rules can redress theseimbalances—for instance, with rules barring imports of products using child

or prison labor, barring the use of wood from endangered forests, or barringgoods produced with processes that violate other global social and

environmental agreements But we have not chosen to adopt these sorts ofrules Further, in some cases, the threat of globalization has been used as abasis for a race to the bottom Before the 2008 crisis, the threat of

globalization was used to argue for financial deregulation—if we didn’t

deregulate, business would move elsewhere We now know that we lost

doubly in giving in to such threats: the economic damage caused by the

deregulation has been enormous, far greater than the short-term gains of thefew jobs created here And as we have seen, the changes foisted on us in thismanner have undermined the long-run performance of the economy and

contributed greatly to our inequality

We could and should have used our position as the largest economy in theworld to set rules that helped all parties, in the U.S and the rest of the world

Consequences of market power for equity and

efficiency

An increase in the market power of a firm shifts wealth from customers to theowners of those firms with market power The decrease in the wealth of

customers is not recorded in accountings of the economy’s capital stock,

while the increase of the value of firms is The ranks of Forbes World’s

Billionaires are peppered with people who attained that position thanks totheir monopoly power in finance, extractive industries, real estate, and

privatized telecommunications.16

The market distortion associated with the exercise of market power

diminishes social welfare Besides creating inequalities, market rents haveother distortionary effects on the economy and on the political system First,rents directly decrease production from what it would be if the economy wereorganized optimally and such rents did not exist.17 Second, rents create

incentives for allocating resources to unproductive rent-seeking activities likeexcessive marketing and sales expenditures and lobbying; the bigger the rent,the greater the incentives for such activities.18 For example, in 2010 thehealth care industry spent $102.4 million lobbying against the AffordableCare Act, while the finance and real estate industries have spent billions

lobbying against passage and implementation of the Dodd-Frank financialreform law.19 Lastly, to the degree that firms engage in lobbying or someother political activity in order to create or preserve rents, it impacts our

political system—and increases the number of adverse outcomes in the

economy and in other spheres of society The original antitrust laws weremotivated by the distortions to our political system as much as to our

economic system

But in order to see this impact play out, we need to look to specific

markets And one of the most dramatic examples is the growth of the

financial sector, which we turn to next

The Growth of the Financial Sector

The finance industry has shifted away from its essential function of allocating capital to productive uses and has moved toward predatory rent-seeking activities In addition to catalyzing the 2008 financial crisis, these activities have slowed growth, increased the risk of future crises, and moved income from the bottom and middle to the top,

increasing inequality.

Widespread deregulation and malign regulatory neglect, beginning in the 1970s and continuing through the early 2000s, enabled reckless growth and malfeasance in

America’s financial sector.

Much of the increased incomes of the top 1 percent arise from the enormous,

unwarranted profits and bonuses collected in the financial sector and derived, in no small part, from wasteful and exploitative activities.

As the rules of the U.S financial system changed over the past generation,the financial sector grew to play a larger, more dominant role in the U.S.economy The rise of finance twisted incentives within both finance and thenonfinancial economy and pulled more of the economy’s rewards from thereal economy into finance and from working families up to the executivesuites Specifically, financial profits and financial salaries have increasinglycome at the expense of the income and savings of everyone else The

inequities have been exacerbated by open and hidden subsidies—not justmassive bailouts (of which the 2008 bailout was only the biggest and mostrecent) but by provisions hidden in the tax system and bankruptcy code thatenrich those in the financial sector at the expense of the public

Finance’s failure to self-regulate

A growing economy requires a well-functioning financial system The

financial sector is essential to running the payment systems, ensuring a flow

of funds from savers to investors, including small and medium-sized

enterprises, and creating information and opportunities for investment Thefinancial sector is also necessary for diversifying investments, managing risk,and providing liquidity and other resources necessary for growth

However, finance needs rules, and the 2008 financial crisis revealed onceagain that financial markets cannot regulate themselves Certain features offinancial markets make them more subject to failure than most other kinds ofmarkets First, activities people undertake in the financial industry create

large externalities, both positive and negative Financial instability, in

particular contagious runs and self-fulfilling panics, can impose massivecosts on the economy.20 Economists at the Dallas Federal Reserve estimatethat the costs of the 2008 financial crisis amounted to 40–90 percent of oneyear’s GDP, as much as $16 trillion in today’s terms.21 Since the beginning

of financial deregulation in the United States and around the world, financialcrises have been increasing in frequency and severity.22

Second, financial markets are plagued with asymmetries of information—situations where one party knows more than the other The existence of suchasymmetries is inevitable, of course, but their magnitude is not, nor is theright to exploit others by taking advantage of these asymmetries Third,

financial markets are lacking in industry competition In particular, since the1970s, the concentration, scale, and scope of the largest banks have grownsignificantly and rapidly, with the share of industry assets held by the top fivebanks growing from 17 percent to 52 percent.23

Starting in the late 1970s, the financial industry lobbied for and

policymakers largely delivered a rollback of regulation with the promise thatthe financial sector would self-regulate.24 Changes to the rules of finance,many of which were in place since financial collapse sparked the Great

Depression, removed the separation of commercial and investment banking,ceilings on deposit rates, and prohibitions on usury—the charging of loan-shark level interest rates The changes didn’t update the rules for new

instruments like derivatives, but they let the financial markets write their ownrules as they expanded into securities that packaged mortgages Enforcementbecame an issue, with federal regulators appointed who didn’t believe inregulation They overruled state-level regulations and enforced less thanvigorously the limited regulations that remained.25

The growth of finance and inequality

Changes to these rules are one of the major drivers of inequality First,

finance has become huge and profitable relative to the rest of the economy.Financial services comprised 7.6 percent of GDP before the crisis, then fell